How to hedge

Bloody Ploughman … Dog’s Snout … Maiden’s Blush … Nonnetit Bastard … not old English swear words, but traditional apple varieties …

A cold winter … a wet August … then a dry September … the perfect conditions for a bumper harvest of apples in 2014.

Across Europe, the orchards have been dripping with a surplus of apples, looking like something out of a cider advert. The UK and Poland have enjoyed a record harvest of apples. The Dutch and Belgian pear harvest is up on last year too.

But the highest ever crop has resulted in rock-bottom prices for apples, with many orchards unable to sell their fresh fruit.

There have been a number of reasons for this … the strength of pound against the euro – the UK’s growing appetite for seedless grapes over traditional apples … pressure from discount supermarkets … and, perhaps most significantly this year, Russia’s ban on imports of EU produce has meant huge numbers of Polish apples flooding the European market.

Mr Putin’s name is mud in Kentish orchards.

Farmers can be very vulnerable to the fluctuating values of their commodities. By the nature of their businesses, they tend to have all their eggs (or apples) in one basket. But those who diversify, can protect themselves.

Rather than selling at below-cost prices to juicers and cider producers, farmers are diversifying into these markets themselves. That way, they can monetize low prices for their fruit.

As traders, it’s considerably simpler for us to diversify than it is for an apple grower.

To hedge ourselves in the market, we don’t need to build a cider press … we just need to click a button on our trading account.

Yet, so few traders think this way.

We stick a stop loss on our trades, and think that’s protection. A stop loss is an exit strategy, at best – but it’s not protecting us from price fluctuations.

Think of it like this … A stop level is like putting a fire escape in your house. A hedging strategy is like protecting your home with a sprinkler system.

One allows us to escape with our lives. The other actually halts the damage.

Why do so few traders actually use hedging?

One reason is the misconception that hedging has to be complex – we just don’t know how to hedge. It’s probably a myth that’s been cultivated by investment funds who want you to pay handsomely for their services.

Some traders I speak to have a block with believing that it can be beneficial to ‘bet against yourself’ – which is essentially what we do when we hedge.

It’s true – hedging will typically reduce profits when things go in our favour. Let’s imagine we’ve got our trade spot on, our profit shoots through the roof … yet, for the hedged trader, some of those profits will be eaten up by the hedge trade.

But the clever thing about hedging is that it combines risk management, with maximizing profits.

How can paying for an ‘insurance policy’ make us more money?

Being a successful trader is as much about not losing money, as it is about making money.

As we’ve seen – lower returns with less volatility, will make us richer in the long term than high returns with more volatility. Add to this, the protection hedging offers from black-swan events, like market crashes (which can be so devastating that traders never come back from) – and we’ve a win-win situation.

We only have to glance around us as what players are doing … almost all firms in the gold mining industry employ hedging in the gold-derivatives market … investment funds wouldn’t dream of being in the market without hedging … even Guatemalan coffee growers hedge their price risk through pricing formulae with exporters.

If you aren’t yet using hedging as standard in your trading – now is the time to wake up to this. It needn’t be complicated – anyone who’s already tried Martin Carter’s Diff Code systems will know how simple and pared back an hedging system can be.

I’d recommend this as a great way to start incorporating this into your trading.

And please, don’t find yourself helpless when prices move against you – if life gives you cheap apples, build yourself an apple press, and make cider!

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